Funding & Investing

Record equity sparks direct listing and SPACs, but what are the risks?

Published: Mar 2021

Roaring equity markets have created a surge in IPOs. New trends are also emerging like direct listing and SPACS are back. Treasury teams weighing the best option need to consider the benefit of banks drumming up investor interest and the strength of their own brand to go it alone. As for SPACS, finance officers need to understand how much of the company they are actually giving up.

Red uniformed drummers in a row

“We will definitely go the IPO route in the next five years,” says Kane Harrison, Founder and CEO of Wombat, an investment platform for retail investors that has just secured £2m seed funding. “Once we reach 2.5-3 million customers we want to list, allowing our customers to invest in our brand.” Of course, 35-year old Harrison’s listing ambitions for the platform he set up in 2017 to simplify the investment process for young people and encourage saving, will be subject to market conditions. In five year’s time the stock market, currently at record highs, may not be doing as well and today’s investor enthusiasm to buy shares in the digital companies rushing to list is particular to the pandemic and lockdown fast-tracking the shift online.

Yet Harrison’s enthusiasm underscores the boom in a type of corporate funding that has spent the last ten years in the doldrums. According to data provider Refinitiv, companies raised more money through stock market listings in 2020 than in any year besides 2007. For sure, Chinese tech companies face an uncertain regulatory environment following authorities halting the US$37bn Hong Kong and Shanghai IPO of payments firm Ant Group, but businesses have still raised almost US$300bn through flotations globally in 2020, including a record US$159bn in the US. Moreover, important new trends are emerging from the boom. A traditional IPO used to be the only game in town. Now SPACs (Special Purpose Acquisition Companies) are back in fashion and more companies say they want to list directly rather than go through a traditional IPO process.

Going direct

The current trend in listing directly began when Spotify went direct in 2018. Back then, executives at the streaming music provider made much of how the company was “re-imagining” the traditional IPO process by ditching the services of big syndicate banks to go it alone on the NYSE. Since then, a small but growing group of companies including Slack, the workplace messaging application, and software companies Palantir and Asana, have also avoided costly investment banking fees to offer shares to institutions and retail investors on an equal basis, allowing them to buy as much as they want and not be held back by allocations. Most recently, Roblox, the video game company, says it too plans to list directly rather than via a conventional IPO.

A direct listing has a few specific characteristics. Companies listing directly aren’t raising more capital – Spotfiy was only listing its outstanding shares (such as those held by employees and early-stage investors), with no plans for either a primary or secondary underwritten offering. Hence there is no need for the services of big syndicate banks responsible for selling shares and drumming up investor interest. This in turn means none of the traditional IPO characteristics like a limited float and preferential treatment for some investors, lock ups and price stabilisation – or the traditional share price “pop.”

Crucially, listing directly on an exchange means the opening share price is established by straight market forces, explains Greg Rodgers, a partner in the New York office of global law firm Latham & Watkins who represented Spotify and the financial advisors in the Asana and Slack direct listings. “Direct listing candidates really value setting the initial trading price at the most efficient price possible. In a traditional IPO, the sale to the public is agreed upon between the company and its underwriters and the market only speaks when the listing on the exchange occurs. Even then, it is somewhat artificial in that the only supply is from the company and the rest is locked up for a traditional 180 days.” In a direct listing, all the available shares for sale and all potential buyers participate in a two-sided price and volume-dependent market, he says. “It is like a normal trading day for a mature public company.”

Money on the table

Going direct also prevents money being left on the table, a bugbear in the IPO process amongst treasury teams whereby under-pricing costs companies dear. In a traditional IPO, underwriters typically set an offer price below where the market price is going to open or expected to “pop,” passing along profits to investors. If the company had raised cash at the share price after the “pop” it could have either got more bang for its buck, or sold fewer shares, explains Jay Ritter, an expert on IPOs at the University of Florida. “Money left on the table is money that is not cash on the balance sheet of the company and an opportunity cost,” he says. “The average money left on the table, plus underwriting commissions, worked out at US$200m per IPO last year. IPOs are very expensive.”

Moreover, regulation could boost the number of direct listings. The Securities and Exchange Commission recently approved rules that allow companies to sell shares in the opening auction when they list directly on NYSE. It gives the green light to raise capital in a direct listing and opens that method of going public to companies needing to raise capital. “As with the direct listings we’ve see to-date, the price for the company shares will be set by pure market forces and the primary sale will make the process more attractive to companies wanting to raise capital,” explains Rodgers, who cautions that details like disclosure and the correct role of the company’s financial advisors in the process still need to be worked out before a “pioneering company” takes the plunge.

The hitch

And there are risks. Despite the benefits, listing direct is only right for companies with strong brands, an easily understood business and investor awareness. “IPOs are sold and not bought,” cautions Jeff Harte, Managing Director, Equity Research at Piper Sandler in Chicago in a reminder of the vital role of banks in selling companies and building muscle behind an IPO. “At the end of the day IPOs are sold and pulling them off without roadshows and sales support of Wall Street is difficult.” For Ritter, this will ultimately confine listing directly to a niche. “Most mid-sized and smaller companies are not going direct,” he says.

Elsewhere, experts flag the process can leave shares thinly followed and without lock-ups, which restrict sales in the early months, vulnerable to falls. An IPO, unlike direct listings, also allow a company to find the sticky public investors at the right price through pre-listing allocations. The Council of Institutional Investors has also cautioned that allowing primary direct floor listing could allow companies to sidestep the typical vetting that comes with a traditional IPO, raising investor risk. “As you can see from Spotify, Slack and Asana, listing directly works best for companies that are fairly large, already have a cross section of investors in their private company investor group, and are going to be well followed by Wall Street analysts and picked up in research coverage,” says Rodgers.

SPACs are back

The traditional IPO is also getting a run for its money from SPACs. One of the hottest trends in US investment circles (UK regulation currently discourages SPAC listings) involves so-called blank check companies with an experienced management team and investment focus, but with no assets, floating on the stock market and raising money from investors. The team then hunt and merge with private companies looking to come to market, allowing companies in the SPAC to obtain a stock market listing and have their shares publicly traded for the first time.

Recent corporate names to take the SPAC route include tourism company Virgin Galactic, the US sports betting firm DraftKings and the electric truck maker Nikola. Luminar Technologies, a driverless vehicle technology supplier which came to market via a SPAC in December, made its 25-year old founder a billionaire in the process. According to the website SPACInsider, some 248 SPACs came to market last year raising US$83bn, while 127 SPACs have raised US$37bn so far this year.

SPACs offer treasury teams a quicker route to market and less regulatory bind. Stock market flotations can be drawn out, involving months of presentations to would-be investors, distracting management from the day-to-day running of their company. SPACs can also be an attractive option for a company struggling to show profits. SPAC disclosures put more emphasis on future revenues in contrast to IPO’s which require audited past financial statements, making it a route for loss making or young companies. It can also be easier for companies to negotiate a price or valuation with a SPAC sponsor or management team than it is via the traditional haggle between investment banks and fund managers too. “There aren’t as many regulatory hurdles or filings, and managers can typically do deeper due diligence with a SPAC – investors like this,” adds Harte.

The risks

But treasury teams navigating the SPAC route face a number of challenges. SPACs can be hit by muted investor enthusiasm, making it harder to raise money. Investors (those buying the shares in the shell company – not the asset management team behind the SPAC) don’t always get the best deal because the asset management team take 20% of the equity. “It’s pretty much a straight dilution away from investors buying the shares – getting investors interested is a hurdle,” says Harte.

Moreover, underlying companies face giving up a large chunk of equity to the SPAC sponsors. “There is no such thing as a free lunch,” says Rodgers. “Anytime you see people making money, you have to figure out where it’s coming from. SPAC sponsors end up owning a large percentage of a public company for a relatively modest investment, and that comes from the ownership of the SPAC’s target company. Whether that makes sense has to be balanced with the offer on the table.”

Another key risk for treasury teams to weigh is the amount of money the SPAC will deliver to the company. “The process involves quite a lot of uncertainty,” warns Ritter. “From an operating company’s point of view, the company will need to understand the terms of the deal and what percentage of the company is being given up. Moreover, after the deal has been negotiated, the SPAC shareholders still have to approve it and there is some uncertainty for the company as to whether they will. This is the risk.”

There is no doubt it’s the perfect time to IPO. Equity markets are roaring in a sure sign that the bull market is coming to an end. Treasury teams mulling the best route to market should talk to their investment bankers and lawyers, explore the likely valuations through an IPO and factor the risks of each process, the price on offer and the consequences of dilution.

As for Harrison, he is unsure what route he will take. For now, his focus is on ensuring the metrics are in place to attract another round of seed funding come the autumn. “It’s all about traction,” he concludes. “Investors want to see how many customers we are onboarding a week, how our customers are investing, how long they are staying on the platform, and how their use of the platform has changed since they first signed up.”

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